Situation: Inefficient rental investment income is holding back couple’s retirement
Solution: Sell rental, use cash to pay off home mortgage, raise RRSP and TFSA balances
A couple we’ll call Harry and Susan, both 58, live in Alberta with their teenager, Morgan. Their monthly income from Harry’s engineering company and Susan’s job in management services in a large manufacturing company adds up to $12,027.
“Can we retire at 65 and maintain our standard of living,” they ask. “Can we also do $75,000 of repairs on our house while paying off two mortgages — $112,026 on our house and $329,832 on a rental property, and still maintain our retirement plans?”
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Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Harry and Susan to test the feasibility of achieving the plans.
The short answer, Moran says, is that yes, they can have it all — pay off the mortgages and retire comfortably at 65 — as long as they make a few moves to solidify their finances.
Morgan’s Registered Education Savings Plan is already well funded with $57,000. With no further contributions but growth at a conservative 3 per cent per year after inflation, it should rise to $64,000 in four years, when Morgan is ready for post-secondary studies. That should be enough for tuition and books for four years if Morgan lives at home, Moran explains.
Raising investment income
Next comes boosting their retirement savings. Harry will be far from the maximum Canada Pension Plan payout and full Old Age Security benefit due to long years working abroad. Therefore they need to boost their RRSPs, a total of $674,330 equally divided between spouses.
First move: Use $99,274 cash to pay down their $112,000 mortgage to $11,726. Then they can use cash flow for annual contributions to their RRSPs in amounts sufficient to push their tax bill down to the top of the first federal bracket, currently about $46,000, Moran suggests.
Next, they should deal with the rental property. The $500,000 building produces annual gross rent of $37,358. The annual expenses for the property add up to $25,678. That leaves $11,680 as net proceeds before tax. Their equity is the building price less the $329,832 mortgage, net $170,168. The annual return on their equity is therefore 6.9 per cent.
The rental’s ratio of debt to value is 66 per cent and borrowing costs a modest two per cent. That suggests the return should be at least twice the present rate. It’s also a 12 hour drive from Harry and Susan’s own home, adding to the difficulty of managing it. The rental mortgage will be paid off in 21 years when Harry and Susan are 79. If mortgage interest rates rise, the paydown could stretch into their 90s. Best bet — sell it, Moran suggests.
If they sell the rental for $500,000 less five per cent selling costs, net $475,000, and pay off the $329,832 debt, they would have $145,000 left. They can use that money to pay off their home mortgage with a balance of $112,000. That would leave about $33,000 for their RRSPs or TFSAs.
Harry and Susan can raise after-tax income by adding to their RRSPs. Each is in a 30.5 per cent bracket, so each dollar of income above $45,917 going to the RRSP generates a 30.5 cent refund. That’s a good first-year return on the money.
They have $145,000 in a corporate account. Their plan was to leave the money in the account to generate profits and pay dividends. New tax rules limit the effectiveness of generating passive investment income in the corporation. Passive investment income has to rise to $50,000 per year — not a problem yet for Harry — before penalties start under the February budget, but a plan to get it out is in order. There are better things to be done with the cash.
Harry has $79,000 of RRSP room, while Susan has $45,000 of room. Money coming out of the corporation can go directly to RRSPs, Moran explains. There would be a tax refund, of course. If their RRSPs with a present balance of $674,330 plus contributions of about $124,000 to fill the room plus annual additions of $20,000 per year grow for the next seven years with a 3 per cent return after inflation, they would become $1,135,100 and provide about $57,900 per year for the following 30 years.
After the mortgage on their home is paid off and their RRSPs topped up, remaining cash can go to Tax-Free Savings Accounts. Added to the $6,000 already in their TFSAs, the approximately $75,000 of cash and tax savings could grow to $186,400 in 2018 dollars with $11,000 annual contributions and growth at 3 per cent after inflation. If this money still generates a 3 per cent average annual return after inflation is paid out for the 30 years to their age 95, it would generate an income of $9,500 per year in 2018 dollars. Money not spent can go to the TFSAs after the couple is retired and no longer eligible for RRSP savings.
The couple’s Canada Pension Plan accounts will provide $6,961 a year to Harry, $10,028 to Susan, and she will have a $12,000 annual company pension as well. Harry can count on $4,576 annually from Old Age Security, Susan, $7,040 annually. Figures are 2018 dollars.
Adding $57,900 per year from RRSPs and $9,500 from TFSAs, the couple would have pre-tax income of about $108,000 a year. With splits of eligible pension income, no tax on TFSA payouts and a 17 per cent average tax rate, they would have about $7,600 a month to spend.
Subtracting mortgage interest, a maintenance reserve, rental property tax, accounting and professional fees from their current monthly allocations of $12,027 gives $6,342.
There would be enough surplus in the budget to accommodate $75,000 of spending for repairs for their house and, that done, surplus income could pay for a new or newer car as the need arises. With a few cuts in the clothing and entertainment budget, they could add to their reserves. “The couple has enough money to maintain their way of life in retirement,” Moran says.
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Retirement stars: Four retirement stars **** out of five